The SEC’s Division of Examinations (the “Division”) issued a risk alert1 (the “Risk Alert”) on the observations of the Division’s staff (the “Staff”) from examinations of investment advisers (collectively, “examined advisers”) associated with wrap fee programs2, including advisers that: (1) served as portfolio managers in, or sponsors of, wrap fee programs; and (2) advised their clients’ accounts through one or more unaffiliated third-party wrap fee programs. As described in the Risk Alert, advisory clients who participate in wrap fee programs generally pay the wrap fee program sponsors a combined “wrap fee” that includes both investment advisory services and execution of transactions. The wrap fee is generally based on the value of the client’s wrap fee program account.
Observations Regarding Deficient Industry Practices
The Staff observed the following common deficient practices:
- Fiduciary duty and recommendations not made in clients’ best interests.
- The examined advisers did not monitor the trading activity in their clients’ accounts, including for “trading-away” from the broker-dealer providing bundled brokerage services included in the wrap fee, or their monitoring activities were ineffective.
- The examined advisers did not have a reasonable basis to believe that the wrap fee programs were in their clients’ best interests.
- Potentially misleading or omitted disclosures, particularly regarding conflicts of interest, fees, and expenses.
- The examined advisers had inconsistent disclosures regarding the same topic, such as the fees and expenses excluded from the wrap fee, in various documents including the firm brochure, the wrap fee program brochure and advisory agreements.
- The examined advisers omitted disclosures or inadequately described conflicts of interest, such as the financial incentives the examined advisers and their supervised persons had to make certain investment recommendations, including mutual fund share classes that charged 12b-1 fees.
- Weak or ineffective compliance policies relating to wrap fee programs.
- The examined advisers did not adopt and implement policies and procedures for key business functions and risk areas, including conducting initial and/or on-going best interest reviews when recommending wrap fee accounts to clients.
- Certain examined advisers adopted inadequate policies and procedures that included inaccurate information about their firm, were not tailored to the adviser’s business, or failed to fully address applicable risks, such as reviewing for trading-away practices, determining the suitability of wrap fee accounts and conducting best execution analysis.
- Several of the examined advisers failed to consistently or fully implement or enforce their compliance policies and procedures, such as not conducting due diligence on third-party portfolio managers recommended to clients and not reviewing client accounts and fee billing.
- A few of the examined advisers failed to perform required annual reviews or performed these reviews inadequately.
Observation Regarding Effective Industry Practices
In its examinations, the Staff observed examined advisers that implemented policies and practices to address their obligations related to the compliance issues identified above, including the following examples.
- Fiduciary duty and recommendations made in clients’ best interests.
- Examined advisers conducted reviews of wrap fee programs – both initially and periodically thereafter – to assess whether the programs recommended to clients are in the best interests of clients, using information obtained directly from clients (e.g., through interviews, discussions, and/or questionnaires).
- Examined advisers periodically reminded clients, after conducting initial best interest reviews associated with the recommendation to participate in wrap fee programs, to report any changes to their personal situations, or financial standing or needs, and investment objectives that might impact the clients’ risk tolerances, investment allocations, and/or recommended investments.
- Examined advisers communicated with clients to prepare and educate clients about wrap fee programs and the differences between non-wrap fee accounts and wrap fee program accounts, including the costs involved.
- Examined advisers provided clients with disclosures regarding the advisers’ conflicts of interest related to transactions executed within the wrap fee programs.
- Examined advisers provided clear disclosures, when recommending wrap fee programs to clients, about whether certain services or expenses are not included in the wrap fee.
- Compliance Programs.
- Written compliance policies and procedures of examined advisers included factors to be used when assessing whether investment recommendations made to clients participating in wrap fee programs, including asset allocations and selection of managers, are in the clients’ best interests.
- Compliance programs required monitoring and validation that the advisers sought best execution for clients’ transactions.
- Compliance policies and procedures defined what the adviser considered to be “infrequently” traded accounts and compliance programs review such accounts to determine whether the wrap fee programs remain in the clients’ best interests.
The Division focused its examinations on wrap fee programs because of the continued growth of investor assets participating in such programs and the conflicts and disclosure practices observed during previous examinations. The Risk Alert highlights the importance for investment advisers that serve as portfolio managers in, or sponsor, wrap fee programs to consider and adopt policies and procedures to address the risks, conflicts, and challenges associated with wrap fee programs. Many of the deficiency points described in the Risk Alert are founded in Regulation Best Interest adopted by the SEC on June 5, 2019 and we expect to see the SEC apply similar best interest-based analysis in future examinations.
Seward & Kissel LLP, and our compliance consulting service SKRC (Seward & Kissel Regulatory Compliance), are available to assist advisers with the issues identified in the Risk Alert.